No one likes making mistakes.
If there’s one aspect of life that we loathe, it’s to admit that something went wrong.
When it comes to investing, humans are also not infallible.
We will, of course, try our best to avoid errors, but it’s a fact that investing involves probabilities and not certainties.
I would go as far as to say that investing is neither black nor white, but is often coloured in shades of grey.
The uncertainty inherent in investment decisions means that both novice and veteran investors will fall prey to mistakes.
Even experienced investors are not immune from these seemingly obvious errors at times.
These mistakes could be due to a lack of understanding of the business, poor emotional control or false beliefs that persist due to ego.
In any case, you need to recognise that it’s much better to learn from others’ mistakes than it is to make your own.
Here are five investment pitfalls that investors need to be constantly wary of.
1. The value trap
The value trap is probably one of the most common yet least talked about mistakes that investors make.
A value trap is defined as an investment that appears cheap using traditional valuation metrics but turns out to be cheap for a good reason.
The problem here is that investors too often fail to identify what constitutes a value trap, which causes them to get continually ensnared.
I have a fairly simple rule for determining if an investment may be a value trap: if it’s too good to be true, it probably is.
Deep value investors normally rummage for cheap stocks in the bargain bin.
This bin normally comprises companies that are either out of favour or have seen consistent deterioration in their financial and operating metrics.
As it is with any bargain hunting, there is a tantalising desire to root out something valuable that other investors may have overlooked.
The idea is, once this gem has been identified, the intrepid investor stands a chance to make multiples of his original investment once the value of the business is recognised by the stock market.
The above sounds a bit like a Cinderella fairy tale.
More often than not, the search to uncover something valuable ends up turning into pumpkins and mice.
Value traps are insidious as they mislead an investor into harbouring more hope than he should rightfully have.
Call it a case of unrequited love, but falling in love with such investments usually ends up being a one-sided affair that will leave you much poorer.
2. Holding on to a losing position
This situation must be familiar to most investors: your investment takes a turn for the worse and starts to decline as the business encounters challenges that seem insurmountable.
As the share price plummets, your brain is telling itself that these problems will soon pass.
Everything is going to turn out just fine.
This type of self-rationalisation is common but it usually ends up being a case of self-deception.
When a business deteriorates, the logical step would be to analyse the reasons for it to do so.
Getting sentimental over a position and holding on longer than you should is damaging for your wealth.
Pride and ego may tell our brains that the business may turn around soon.
But in the vast majority of cases, turnarounds seldom, if ever, occur.
3. Selling a winner way too early
On the flip side, there’s also what investors will refer to as a “happy problem”.
In particular, holding a stock that is steadily rising in price.
Your ego is sated, your investment thesis has been validated, and you enjoy a rush of blood to your head.
After the initial euphoria dies down, a sudden sense of fear sets in.
What if these gains vaporise overnight? After all, the profits you are enjoying now have not been crystallised.
Not until you sell the stock.
Such emotions goad investors to quickly lock in their profits for fear of losing their hard-earned gains.
The problem with this action is that a great business can continue to grow and compound your money for many years to come.
Let’s illustrate this with an example.
Let’s assume you invested in Amazon (NASDAQ: AMZN) at US$200 back in May 2011.
More than two years later, the e-commerce giant’s share price has registered a healthy 50% gain.
No one would argue that a 25% per annum return is shabby.
You happily close out your position to enjoy your profits, only to see Amazon continuing its gravity-defying climb up to around US$3,200 today.
If you had held on to shares instead of selling them prematurely, you’d be staring at a 16-fold gain on your investment.
4. Buying into false promises
Every investor who has the opportunity to speak to a company’s CEO knows how persuasive a leader can be.
The head honcho’s job entails more than just running the company well to maximise value for its shareholders.
As the CEO of the company, it is his or her job to present an optimistic view, market the company to potential investors while painting a rosy picture of its financial health.
If you’re trying to find out if a company makes a great investment, listening to the CEO talk is probably not the most objective method.
This is not to say that every CEO embellishes, but that there is a tendency to highlight the positives while declining to mention the negatives.
At best, the company may be over-promising but under-delivering.
But at worst, investors may find themselves buying into false promises and falling head over heels in love with a company that is unable to deliver over the long term.
5. Downplaying the risks
This final pitfall happens to the best of us.
When an investment is performing swimmingly well, it’s easy to either ignore or downplay the risks associated with it.
There are two main risks with an investment that you should not ignore — namely business risk and valuation risk.
Business risk represents something that could go wrong that adversely impacts the health of the business.
A myriad of reasons can contribute to this decline, from the entrance of a more aggressive competitor, product obsolescence or a failure to innovate.
A smart investor needs to remain watchful and alert of any changes in the business environment that may have an impact on their investments.
Complacency breeds inattention that may lead to permanent losses should the business deteriorate.
Valuation risk occurs when you purchase an investment when conditions are ebullient.
By buying into optimism, you set yourself up for disappointment when well-laid plans end up in shambles.
Get Smart: Constantly learning and growing
If reading the above has caused you to break out in cold sweat, relax.
Everyone is prone to all the mistakes mentioned above but to varying degrees.
The key is to be cognizant of these pitfalls and to pull yourself from the brink should you recognise the signs of being caught in one of them.
As investors, we all need to constantly learn and grow.
Over time, we will become Smart Investors who successfully can grow our wealth.
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Disclaimer: Royston Yang does not own shares in any of the companies mentioned.